Correctly pricing a new product or service is vital. Too high and you get no customers, too low and you leave money on the table. Either way you burn through cash so your innovation, and possibly your company, fails.

Pricing is a fiendishly complicated topic. There are more than 7,000 books listed on Amazon dealing with different pricing strategies and methods. And yet, it is something the innovator must deal with throughout the innovation process.

Why? Surely if you are in a large and established business other people are responsible for pricing, and if you are in a small business or a lone entrepreneur, the first task is to have a new product to price. Why worry about it while innovating?

Thinking about pricing at an early stage is important because it can help to guide your innovation journey. It can tell you where the biggest opportunities are, and where you need the most innovation. It is one of the constraints that should be helping to shape your innovation.

Three numbers shape price

I have found three numbers useful in trying to work out the price of a new product:

  1. Cost – how much will it take to deliver a unit of product?
  2. Contribution – how much do I need to make on top of basic costs to cover everything else I need to pay for?
  3. Value – what is my product worth to my target customer?

Each of these is slippery and hard to quantify, but they give you three different views on the pricing challenge and help you to understand where your innovation is strong and where it is weak given your target market.

What does it cost me to supply?

The basic cost of the product is the first of the key numbers. What are the costs exclusively associated with the product, and that scale with volume. Raw materials costs (if any), manufacturing or processing costs, and delivery costs.

In some cases, this is all you need to know. One innovation I worked on was a commodity material targeted at a single major customer. Raw material costs dominated and were very volatile. We both needed a way to feel comfortable with the price, so we worked ‘open book’. The price for each month’s production was actual raw material costs, plus actual delivery costs, plus a manufacturing fee that included an agreed return on capital and agreed overhead charges. The customer also guaranteed a certain level of demand for the product.

It was not the most profitable product, but the income was steady and it enabled trust on both sides when raw material costs were shifting. This kind of approach is often found in regulated markets like water and electricity.

You should have a pretty good idea of the cost to supply. Where it gets more complicated is trying to figure out how the costs will change as volume increases. Some products have high set up costs, which get spread over more units as the volume goes up. Innovative products, particularly in engineering and the process industries get cheaper with experience – the “learning curve”.

You may start with third-party production and fulfilment for market testing volumes and initial launch. That keeps your up-front investment down, but the unit cost high. As you get more confident you can bring some of those third party services in-house if it reduces costs and fits your strategy.

It’s OK to start off with high basic supply costs to test a market, but eventually you are going to have to reach a cost structure that fits with the other numbers – contribution and value.

If it doesn’t work, it is back to innovation. Can I change the design, the materials, the delivery costs? Can I take out some of the features without losing the essence of the offer to the customer?

What about all my other costs?

The contribution your innovation needs to make to your business must cover all the other costs that don’t scale with volume.

The marketing campaign for your innovation, your office and factory space, servers and telecoms, insurance and taxes, phones, staff salaries, investment in future innovations, etc.

If you are in a large and established business, it is fairly straightforward. You tell the finance department how much you expect to sell and what corporate resources you will use, and they will tell you how much you have to ‘contribute’ to the company well-being. It is often a nasty surprise!

In a small business or start-up, the key is to make sure you have not forgotten anything. Make sure you have included every cost you can imagine.

The big unknown is what is the volume going to be? To understand the contribution per unit, you need a range of estimates; successfully launched but limping, a realistic estimate of sales growth, and brilliant success.

The most common problem seen in start-ups is that sales growth is much slower than anticipated. What is your plan for that scenario?

Contribution is less amenable to innovation. It represents the costs you are incurring to run the business. Innovation in tax accounting has got many businesses into trouble.

What you can do is track and have a plan to cut those costs if necessary. What is essential to delivering your plan and what costs would be nice but aren’t critical? A colleague of mine used to say that once a business had a fountain in the lobby it was time to bail out.

What is it worth?

What is your innovation worth to your target customers? What does it enable them to do that they couldn’t do before, and what would they pay for those benefits?

There are various ways to estimate value. The best is to look hard at what the target user is currently trying to do. Where are they dissatisfied? Where are the pain points? What are their dream solutions? What extra benefits can your innovation offer?

Business to business (B2B) and business to consumer (B2C) markets are different.

In B2C it is easier to offer intangible benefits such as novelty, cool design and so on. For some desirable product types (for example clothing and consumer electronics) you can charge extra for exclusivity or early access.

B2B tends to focus more on tangible benefits. How is your innovation going to help them become more successful? How much extra money are they going to make, and what could your share be?

It is dangerous to try and estimate value without understanding how the customer will use your product.

Selling chemicals to a major multinational, my team were getting to the crux of the price negotiation. Suddenly the buyer said, “I’ve just realised, you have no idea what I use this product for do you?”. An evil grin spread across their face and my heart sank. All the power was now with the buyer because I did not know what value my product represented to them. From then on I worked very hard to understand how a customer would use a new product and what benefits it could bring.

Sometimes you will create a product that addresses a completely new and untapped need. But it is rare. Much rarer than most innovators think. Generally, the user has some alternative way of meeting their needs, and this alternative has a price. That is your baseline or reference price. You may think that you have a much better solution, but that reference price is in their mind, and if you want to charge more you have to come up with a very convincing argument.

It is important to understand that the value the customer sees has nothing whatsoever to do with your costs. You may find that what a product is worth to the customer is vastly more than the costs you incur to deliver it. In which case, congratulations you have a winner! But it may be that the value is less than your costs and contribution, and you cannot fight that.

“…value the customer sees has nothing whatsoever to do with your costs.”

It is no good arguing that customers should appreciate the brilliance of your work; that is your problem, not theirs. I know that your innovation is really clever, mine were too, but they still bombed if I didn’t make sure they delivered value for money.

If there is insufficient value in the innovation for the cost base, you must find additional valuable benefits for the customer, find a new customer with different needs, or reduce your costs.

The price is in there somewhere!

Trying to determine price is like a sculptor trying to release an image from a block of stone. You cut away bits where the sculpture isn’t, and gradually reveal the shape inside. With price you have a large space of possible answers, and you use different perspectives to gradually carve away areas that don’t work. Areas where the price is definitely not hiding.

Price must be more than £x because that is the cost of my raw materials. It should be no more than £y because that is the reference price in the market, and I don’t think I have a convincing case why customers should pay more.

Perhaps I can find an alternative manufacturing route or supplier who could cut my cost of production. Perhaps there are additional benefits to my innovation that will encourage the customer to pay a bit more.

And so on…

The biggest mistake is to be so excited by your idea that you ‘adjust’ your estimates to reach the right answer. My idea is so obviously brilliant, I’ll just nudge these soft input numbers a bit. A Dutch CFO friend used to say you should be careful not to “reken jezelf rijk” – calculate yourself rich.

As part of the model of innovation as a conversation rather than a linear process, pricing information is one of the guides. Where do I need to focus? What do I need to do next?

Thinking about price must be an integral part of your innovation journey; right from the beginning.

Careful Pricing Is Vital For Successful Innovation
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